Interest rates will rise and stay high, not fall, as inflation rises
The latest consumer inflation data has helped solidify a new consensus around tighter interest rate policy this year ahead of the Federal Reserve’s 2023 reversal. But Fed watchers may still be under pressure. – estimate the problem of inflation; they should bet on a rate plateau rather than a pivot.
When the Department of Labor released its consumer price index in August, there was little doubt that inflation was broad, sticky and demand-driven. Consider that the Cleveland Federal Reserve’s median CPI, which removes outliers to measure core inflation, rose a record 6.7% from its level a year earlier. As Michael Ashton of Enduring Investments notes, about 70% of the components of the CPI rose at an annual rate above 6% last month. In the decade before the pandemic, that share was 10% or less.
Economists and investors now expect bigger rate hikes at each of the Fed’s three remaining meetings this year, starting with an increase of at least 0.75 percentage points on September 21 and ending by a key rate of 4% to 4.5% at the start of next year. . Still, traders are still betting on a quick pivot from the Fed, according to CME data, with around half a percentage point in rate cuts expected between March and December next year.
It’s more and more madness. The latest CPI data undermines the consensus view that the worst is over.
First, the decline in headline inflation reflected falling energy prices. But China’s reopening after Covid shutdowns will boost demand for oil, and RBC global energy strategist Michael Tran says a host of variables, including an end to drawdowns on government strategic reserves, present upside risks for oil.
Second, labor shortages will continue to drive up service prices.
Third, it will take about a year for the first signs of falling house prices to appear in inflation data, in which housing accounts for a quarter to a third of the major baskets. As Ashton of Enduring Investments points out, all it would take to reach past CPI highs, excluding food and energy, is a 0.4% rise in September from August. Last month, core prices rose 0.6% month-over-month.
One explanation for the Fed’s lingering pivot bets is the slowdown in August’s PPI which was reported a day after the CPI. The logic is that the deceleration in wholesale prices will trickle down to consumers, auguring weaker CPI impressions. But this assumption is wrong.
But “let’s talk about what’s happening now, rather than what happened to the PPI last month,” says Richard Farr, chief market strategist at Merion Capital.
It is futile to extrapolate from August PPI data when prices for natural gas, diesel, corn, cotton and lumber this month are up 124%, 107%, 37 %, 24% and 19%, respectively, from their annual levels. earlier.
Another reason for the persistence of pivot expectations is the idea that more aggressive monetary policy would theoretically lead to a faster and deeper recession. If Deutsche Bank economists are correct and the Fed drops to 5% early next year, a deeper-than-expected slowdown is inevitable. But it may not be so simple this time, given the speed of inflation and its nature.
Vincent Deluard, director of global macro strategy at StoneX Financial, outlines several reasons why the Fed has no choice but to remain hawkish, at least until next year.
First, the central bank’s expectations to cut rates next year reflect what it calls “perfect disinflation,” a scenario only possible if energy prices continue to fall. That’s a tough bet, given that they’re currently driven by geopolitics at least as much as economics. Domestic supply is tight and reports suggest the Biden administration could start filling the strategic oil reserve sooner than expected.
Second, inflation is not just sticky, but structural. A sizable swath of workers is still missing from the workforce — and unfavorable demographics suggest the problem isn’t going away — as the transition to green energy requires more resources for similar production.
Third, persistent inflation breeds higher inflation because the longer it lasts, the more it changes behaviors and expectations. It is played. Consider the 24% wage increase and $11,000 immediate payout for engineers and locomotive conductors as part of the deal announced last week to avert a US railroad strike. And think of the record drop in bank deposits in the second quarter, a sign that households are leaving less money in the bank and spending it faster.
Fourth, Deluard predicts an increase in the velocity of money flow as inflation squeezes budgets, households keep less in the bank, and credit card balances rise. For context, money velocity is the number of times a dollar is spent buying goods and services per unit of time. The increased speed means more transactions take place. Velocity plunged at the start of the pandemic as deposits surged and loans fell, but there are early signs of a recovery to come as inflation squeezes budgets and card balances credit increases.
Even a small acceleration in momentum at a time of high money supply could propel prices higher. Deluard says such an advance would offset the downward pressure on money supply from the Fed’s quantitative tightening program.
Rising loan-to-deposit ratios illustrate Deluard’s point. Deposits are falling, while lending is growing by double digits at major banks, and Deluard calculates that a return to a pre-Covid loan-to-deposit ratio of 75% would require the issuance of around $2.5 trillion in new loans by the big four US banks alone. The trend is better for small banks; Deluard notes that the loan-to-deposit ratio of the
KBW Regional Banking Index
(ticker: KRX) has recovered 77% in the last quarter from a low of around 70%.
Sid Dinsdale, chairman of Pinnacle Bancorp, says his bank’s loan-to-deposit ratio is finally starting to rise to 69% from 66% last year as rising interest rates only chill mortgage lending so far.
Said Dinsdale: “The sky is clear, but a storm will come at some point.” The problem is that high inflation is part of the storm and may persist despite it.
Write to Lisa Beilfuss at [email protected]